Transcript

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In this show you will learn the psychology behindinvesting, skill, your level of wealth/utility, and how algorithms are smarter than experts.

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Investing A venture capitalist will never be told that the probability of success for a start-up in its early stages is “very high.” When a venture capitalist looks for “the next big thing,” the risk of missing the next Google or Facebook is far more important than the risk of making a modest investment in a start-up thatultimately fails. The goal of venture capitalists is tocall the extreme cases correctly, even at the cost of overestimating the prospects of many other ventures.

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Buyers & Sellers The buyers and sellers know that they have the sameinformation; they exchange the stocks primarily because they have different opinions. If all assets in a market are correctly priced, no one can expect either to gain or to lose by trading. Perfect pricesleave no scope for cleverness, but they also protect fools from their own folly. For the large majority of individual investors, taking a shower and doing nothing would have been a better policy than implementing the ideas that came to their minds.

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Past Events I have heard of too many people who “knewwell before it happened that the 2008 financial crisis was inevitable.” When an unpredicted event occurs, we immediately adjust our view of the world to accommodate the surprise.We have an imperfect ability to reconstruct past states of knowledge.

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The Business Book “Fix”The illusion that one has understood the past feedsthe further illusion that one can predict and control the future. These illusions are comforting. They reduce the anxiety that we would experience if we allowed ourselves to fully acknowledge the uncertainties of existence. We all have a need for the reassuring message that actions have appropriate consequences, and that success willreward wisdom and courage. Many business books are tailor-made to satisfy this need.

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Skill A basic test of skill: persistent achievement. The diagnostic for the existence of any skill is the consistency of individual differences in achievement. The illusion of skill is not only an individual aberration; it is deeplyingrained in the culture of the industry. Facts that challenge such basic assumptions - and thereby threaten people’s livelihood and self- esteem - are simply not absorbed. The mind does not digest them.Skill in evaluating the business prospects of a firm is not sufficient for successful stock trading, where the key question is whether the information about the firm is already incorporated in the price of itsstock. Traders apparently lack the skill to answer this crucial question, but they appear to be ignorant of their ignorance.

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The Measure of WealthDaniel Bernoulli argued that a gift of 10 ducats hasthe same utility to someone who already has 100 ducats as a gift of 20 ducats to someone whose current wealth is 200 ducats.The psychological response to a change of wealth is inversely proportional to the initial amount of wealth.A decision maker with diminishing marginal utility for wealth will be risk averse.

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Risk & UtilityIn mixed gambles, where both a gain and a loss are possible, loss aversion causes extremely risk-averse choices. In badchoices, where a sure loss is compared to a larger loss that ismerely probable, diminishing sensitivity causes risk seeking. Diminishing marginal utility: the more leisure you have, the less you care for an extra day of it, and each added day is worth less than the one before. Similarly, the more incomeyou have, the less you care for an extra dollar, and the amountyou are willing to give up for an extra day of leisure increases. A mistaken assumption: that your utility for a state of affairsdepends only on that state and is not affected by your history.

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“For Exchange” When you shop for shoes, the merchant who gives up the shoes in exchange for money certainly feels no loss. Indeed,the shoes that he hands over have always been, from his pointof view, a cumbersome proxy for money that he was hoping to collect from some consumer. Furthermore, you probably do not experience paying the merchant as a loss, because you were effectively holding money as a proxy for the shoes you intended to buy. Both the shoes the merchant sells you and the money you spend from your budget for shoes are held “for exchange.”They are intended to be traded for other goods. Other goods,such as wine and Super Bowl tickets, are held “for use,” to be consumed or otherwise enjoyed.

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The Gambling Mantra Rehearse the mantra that will get you significantly closer toeconomic rationality: ‘you win a few, you lose a few.’ The main purpose of the mantra is to control your emotional response when you do lose. The mantra works when the gambles are genuinely independent of each other; it does not apply to multiple investments in the same industry, which would all go badtogether. It works only when the possible loss does not cause you to worry about your total wealth. If you would take the loss as significant bad news about your economic future, watch it! It should not be applied to long shots, where the probability of winning is very small for each bet. If you havethe emotional discipline that this rule requires, you will never consider a small gamble in isolation or be loss averse for a small gamble.

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In the Short Term… Broad framing blunted the emotional reaction to losses and increased the willingness to take risks. The combination of loss aversion and narrow framing is a costly curse. Individual investors can avoid that curse, achieving the emotionalbenefits of broad framing while also saving time and agony, by reducing the frequency with which they check how well theirinvestments are doing. Closely following daily fluctuations is a losing proposition, because the pain of the frequent small losses exceeds the pleasure of the equally frequent small gains.The deliberate avoidance of exposure to short-term outcomes improves the quality of both decisions and outcomes.

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Investing Wrap-up Money is a proxy for points on a scale of self-regard and achievement. Finance research has documented a massive preference forselling winners rather than losers - a bias that has been givenan opaque label: the disposition effect. The disposition effect is an instance of narrow framing. The investor has set up an account for each share that she bought, and she wants to close every account as a gain. A rational agent would have a comprehensive view of the portfolio.The sunk-cost fallacy keeps people for too long in poor jobs, unhappy marriages, and unpromising research projects.

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Algorithms Each of these domains entails a significant degree of uncertainty and unpredictability. Wedescribe them as “low-validity environments.” Inevery case, the accuracy of experts was matched or exceeded by a simple algorithm.

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Clinical vs. Statistical Prediction pt. 1 Orley Ashenfelter has offered a compelling demonstration of the power of simple statistics to outdo world-renownedexperts. Ashenfelter wanted to predict the future value of fine Bordeaux wines from information available in the year they are made. Ashenfelter converted that conventional knowledge into a statistical formula that predicts the price of a wine - for aparticular property and at a particular age - by three features of the weather: the average temperature over the summer growing season, the amount of rain at harvest-time, and thetotal rainfall during the previous winter. His formula provides accurate price forecasts years and even decades into thefuture. Indeed, his formula forecasts future prices much more accurately than the current prices of young wines do.

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Clinical vs. Statistical Prediction pt. 2 Ashenfelter’s formula is extremely accurate - the correlation between his predictions and actual prices is above .90. Why are experts inferior to algorithms? One reason, whichMeehl suspected, is that experts try to be clever, think outside the box, and consider complex combinations of features in making their predictions. Complexity may work in the odd case, but more often than not it reduces validity. Simple combinations of features are better. Human decision makers are inferior to a prediction formulaeven when they are given the score suggested by the formula! They feel that they can overrule the formula because they have additional information.

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To Maximize Predictive Accuracy… Final decisions should be left to formulas, especially in low-validity environments. It is possible to develop useful algorithms without any prior statistical research. Simple equally weightedformulas based on existing statistics or on common sense are often very good predictors of significant outcomes.Marital stability is well predicted by a formula: frequency of lovemaking minus frequency of quarrels.

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To Hire the Best Possible Person… First, select a few traits that are prerequisites for success in this position (technical proficiency, engaging personality, reliability, and so on). Don’t overdo it - six dimensions is a good number. The traits youchoose should be as independent as possible from each other, and you should feel that you can assess them reliably by asking a few factualquestions. Next, make a list of those questions for each trait and think about how you will score it, say on a 1–5 scale.Collect the information on one trait at a time, scoring each before you move on to the next one. Do not skip around. To evaluate each candidate, add up the six scores.Firmly resolve that you will hire the candidate whose final score is the highest, even if there is another one whom you like better - try to resist your wish to invent broken legs to change the ranking.

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In this show you will learn about your need for an outside view, optimism (is it good or bad), how your mind handles losses, and more!

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Outside View Baseline prediction: the prediction you make about a case if you know nothing except the category to which it belongs. The baseline prediction should be the anchor for further adjustments. People who have information about anindividual case rarely feel the need to know thestatistics of the class to which the case belongs.

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The Planning Fallacy The prevalent tendency to underweight or ignoredistributional information is perhaps the major source of errorin forecasting. Planners should therefore make every effort to frame the forecasting problem so as to facilitate utilizing all the distributional information that is available. This may be considered the single most important piece of advice regarding how to increase accuracy in forecasting through improved methods. The greatest responsibility for avoiding the planning fallacy lies with the decision makers who approve the plan. If they do not recognize the need for an outside view, they commit a planning fallacy.

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Executives too easily fall victim to the planning fallacy. In its grip, they make decisions based on delusional optimism rather than on a rational weighting of gains,losses, and probabilities. They overestimate benefits andunderestimate costs. They spin scenarios of success while overlooking the potential for mistakes and miscalculations. As a result, they pursue initiatives thatare unlikely to come in on budget or on time or to deliver the expected returns - or even to be completed. In thisview, people often (but not always) take on risky projects because they are overly optimistic about the odds they face. This is an explanation of why people litigate, why they start wars, and why they open small businesses.

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OptimistsOptimistic individuals play a disproportionate role in shaping our lives. Their decisions make a difference; they are the inventors, theentrepreneurs, the political and military leaders - not average people. They got to where they are by seeking challenges and taking risks. They are talented and they have been lucky, almost certainly luckier than they acknowledge.The people who have the greatest influence on the lives of others arelikely to be optimistic and overconfident, and to take more risks than they realize.These persistent (or obstinate) individuals doubled their initial losses before giving up. Significantly, persistence after discouraging advice was relatively common among inventors who had a high score on a personality measure of optimism.

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Entrepreneurial OptimismI have had several occasions to ask founders and participants in innovative start-ups a question: To what extent will the outcome of your effort depend on what you do in your firm? This is evidently an easy question; the answer comes quicklyand in my small sample it has never been less than 80%. Even when they are not sure they will succeed, these bold peoplethink their fate is almost entirely in their own hands. They aresurely wrong: the outcome of a start-up depends as much on the achievements of its competitors and on changes in the market as on its own efforts. However, entrepreneurs naturally focus on what they know best - their plans and actions and the most immediate threats and opportunities,such as the availability of funding. They know less about their competitors and therefore find it natural to imagine a future in which the competition plays little part.

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Can a CFO forecast the S&P?A survey in which the chief financial officers of largecorporations estimated the returns of the Standard & Poor’s index over the following year. The Duke scholars collected 11,600 such forecasts and examined their accuracy. The conclusion was straightforward: financial officers of large corporations had no clue about the short-termfuture of the stock market; the correlation between their estimates and the true value was slightly less than zero! When they said the market would go down, it was slightly more likely than not that it would go up.

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Premortem When the organization has almost come to an importantdecision but has not formally committed itself, Klein proposes gathering for a brief session a group of individuals who areknowledgeable about the decision. The premise of the sessionis a short speech: “Imagine that we are a year into the future.We implemented the plan as it now exists. The outcome was a disaster. Please take 5 to 10 minutes to write a brief history of that disaster.” Premortem has two main advantages: it overcomes the groupthink that affects many teams once a decision appears to have been made, and it unleashes the imagination of knowledgeable individuals in a much-needed direction.

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LossesA single cockroach will completely wreck the appealof a bowl of cherries, but a cherry will do nothing at all for a bowl of cockroaches.Bad emotions, bad parents, and bad feedback have more impact than good ones, and bad informationis processed more thoroughly than good. The self is more motivated to avoid bad self-definitions than to pursue good ones. Bad impressions and bad stereotypes are quicker to form and more resistant to disconfirmation than good ones.

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Asymmetry of LossLoss aversion creates an asymmetry that makes agreements difficult to reach. The concessions you make to me are my gains, but they are your losses; they cause you much morepain than they give me pleasure. Inevitably, you will place a higher value on them than I do.Negotiators often pretend intense attachment to some good. Although they actually view that good as a bargaining chipand intend ultimately to give it away in an exchange. Because negotiators are influenced by a norm of reciprocity, a concession that is presented as painful calls for an equally painful (and perhaps equally inauthentic) concession from the other side.

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Don’t Regret Action People expect to have stronger emotional reactions (including regret) to an outcome that is produced by action than to the same outcome when it is produced by inaction. Be explicit about the anticipation of regret. People generally anticipate more regret than they will actuallyexperience, because they underestimate the efficacy ofthe psychological defenses they will deploy - which they label the “psychological immune system.” Their recommendation is that you should not put too muchweight on regret; even if you have some, it will hurt less than you now think.

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Gambling Would you accept a gamble that offers a 10% chance to win $95 and a 90% chance to lose $5? Would you pay $5 to participate in a lottery thatoffers a 10% chance to win $100 and a 90% chance to win nothing? A bad outcome is much more acceptable if it is framed as the cost of a lottery ticket that did notwin than if it is simply described as losing a gamble.We should not be surprised: losses evokes stronger negative feelings than costs.

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Experiencing Confusing experience with the memory of it is a compelling cognitive illusion - and it is the substitution that makes us believe a past experience can be ruined. The experiencing self does not have a voice. The remembering self issometimes wrong, but it is the one that keeps scoreand governs what we learn from living, and it is the one that makes decisions. What we learn from the past is to maximize the qualities of our futurememories, not necessarily of our future experience.

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What is Your Emotional StateOur emotional state is largely determined by whatwe attend to, and we are normally focused on our current activity and immediate environment.To get pleasure from eating, for example, you must notice that you are doing it.Americans were far more prone to combine eatingwith other activities, and their pleasure from eating was correspondingly diluted.

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Goals Goals make a large difference. Nineteen years after they stated their financial aspirations, many of the people whowanted a high income had achieved it. Each additional point on the money-importance scale was associated with an increment of over $14,000 of job income.The goals that people set for themselves are so important to what they do and how they feel about it that an exclusive focus on experienced well-being is not tenable. We cannothold a concept of well-being that ignores what people want. Nothing in life is as important as you think it is when you are thinking about it.

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